2007 was a tough year for Bear Stearns, a New York based investment bank. Reeling from the mortgage crisis, the firm had booked significant losses, two of its hedge funds crashed in spectacular fashion, and its longtime CEO resigned in January 2008. Nevertheless, the firm by most measures was still financially healthy, and its new CEO delivered a profitable 1st quarter in 2008. However, over the course of a single week in March 2008, Bear Stearns, as a company, ceased to exist.
Bear Stearns was the smallest (but still enormous) member of the 5 major U.S. investment banks . It sat in the middle of the global financial markets, operating various business lines across a number of geographies.
The Company earned its reputation largely through the strength of its Sales & Trading business. The division, Bear’s largest, served as a middle man in the financial markets. When clients (e.g. such as investment funds and other brokers) wanted to trade financial securities, Bear would commit to buy from or sell to them as a trusted intermediary, pocketing the difference between the prices at which it bought and sold. The firm also profited from its own bets placed in the market. The vast majority of the securities traded consisted of complex and long-term instruments such as bonds, mortgages, and esoteric financial products. Each day, billions of dollars of these financial securities flowed through Bear’s trading desks.
What’s the Problem?
How a firm finances its operations is often perceived as secondary to the actual operations, but for an investment bank like Bear Stearns, how it financed its business was fundamental to its operations. And it was in this aspect that Bear’s business and operational models diverged.
Despite the enormous volume of trades, Bear earned only a small percentage on each trade. In order to generate the returns required to stay competitive in the industry, Bear (like other investment banks) borrowed an immense amount of money to support its operations. At the end of 2007, Bear owned $395 billion of assets, of which only $12 billion was supported by its own capital. In other words, for every $1 Bear used, it borrowed an additional $32. This ‘financial leverage’ magnified returns, allowing the Company to turn a business that collected pennies into a very profitable venture.
In the debt markets, it’s often true that the shorter the duration of a loan, the cheaper it is. Unsurprisingly, Bear went as short as possible. Despite the ‘investment bank’ moniker, Bear was not actually a bank; it did not have access to federally insured bank deposits. Instead, much of its debt (~$125 billion) was comprised of ‘repo agreements’ – loans that lasted only a few days, sometimes even overnight – that Bear would continually ‘roll’ (i.e. renew) daily. Effectively, Bear’s lenders had to give the Company a vote of confidence every morning before it could open for business.
To most, this model should raise eyebrows. Bear Stearns was in the business of trading and investing in long term assets that could not be sold quickly or easily, but chose to use very short-term debt in prodigious amounts to operate that business. This model was predicated on the collective trust of its lenders and trading clients…their trust that when they asked for their money back, Bear could provide it.
Now You See it…
In March 2008, Bear Stearns lost that trust. On Monday the 10th, an otherwise unremarkable day, rumors inexplicably began coursing through Wall Street that Bear was running out of cash. The bank certainly had recent stumbles, but it was profitable and sat on a comfortable cash cushion of $18 billion. Despite these facts, the unfounded rumors grew and eventually led to a rout. Clients clamored for their money and refused to trade with Bear, and its lenders refused to roll their loans. And though Bear’s assets were worth more than its obligations, it wasn’t able to cash out of those investments quickly enough to replenish its hemorrhaging cash reserves. By that weekend, the rumors became self-fulfilling – Bear had run out of cash. JP Morgan (with the government’s help) had to swoop in and acquire the imploding Bear Stearns for $2/share, down from the $70/share it had been at the beginning of the week .
Where Do We Go From Here?
There were a number of other business and oversight issues that contributed to the Bear Stearns’ woes, but ultimately, a precarious operating model that didn’t support the business model allowed the Company to be brought to its knees by nothing more than rumors.
Today, in an effort to rationalize their models, most banks have significantly reduced their use of debt and favor more stable, reliable forms of debt over short-term ‘repo’ loans. Let us hope that the management teams, and the regulators who oversee them, do not forget the lessons learned from Bear Stearns.
- The others in order of size: Goldman Sachs, Morgan Stanley, Merrill Lynch, and Lehman Brothers
- JP Morgan later revised its offer to $10/share in response to a revolt by Bear’s shareholders
- Bear Stearns company filings
- SNL Financial